Forgive Us Our Debts?

The war between lenders and borrowers.

Irwin M. Stelzer

That seems to be what the Greeks are discovering—that they have less to lose by default, with all of its consequences, than by trying to be Germans.

One of the most surprising aspects of the financial crises being played out around the world is the failure of policymakers to concede perhaps the most important underlying fact: This is a war by creditors, in control of the institutions of power, to saddle debtors with the cost of the errors in which both borrowers and lenders are complicit. It is in its way very much like some past debtor-creditor brawls: farmers vs. mortgage lenders, hard money financiers vs. those who wanted to avoid crucifying mankind on a cross of gold, Latin American dictators vs. foreign bankers.

Start with Europe. In Greece, Spain, Ireland, Portugal, France, the Netherlands, and Belgium—that may prove to be only a partial list when all the numbers are in—citizens are being asked to tighten their belts, to tolerate austerity-induced joblessness that has driven economies into recession and eurozone unemployment rates into double digits. They are being asked to do without some of the social services to which they have grown accustomed, some of those services the frosting on an already-rich welfare cake, some of them essential to a minimal standard of living for the poor. They are being asked to pay higher taxes on their incomes, property, and wealth at a time when their real incomes are declining.

Why? To prevent the bankruptcy of some sovereign governments, a bankruptcy that would impose losses on the owners of European bank stocks and would threaten the euro, a currency based on the shaky assumption that fiscal union is not a necessary concomitant of monetary union. The end of the euro, of course, would mean an increase in joblessness—among the bureaucrats who by the thousands inhabit the best flats and restaurants of Brussels, and earn salaries and benefits that are the envy of national politicians. The Eurocrats contend even now that they need an inflation-busting increase in their budget, financed if necessary by higher taxes on residents of the European Union and on the financial services industry, primarily in Britain, which had the good sense to hang onto the pound sterling rather than enter the eurozone.

On to the United States. Some debtors are losing their homes. Many of them were imprudent to take on mortgage debt they could not possibly repay, but some were wiped out because the economic downturn, for which they were in no way responsible, destroyed long-held jobs or drove down property values. These debtors are the collateral damage of macro-economic disasters unleashed by -others. The lenders, institutions presumably schooled in the fine art of risk management, and armed with information from staffs of economists and the fabled quants, were not merely innocent victims of the debt crisis. They made loans with their eyes wide open, unless blinded by the thought that they were too big to fail, or that they could simultaneously make bad loans and sell them to trusting clients. The borrowers lost homes and equity, the lenders were bailed out, and although shareholders in lending institutions did not escape unscathed, many of the bankers to whom they entrusted the management of their wealth did. Compare the plight of an evicted family with the banker fighting a rearguard action to prevent shareholders from reducing his bonus by the odd million or two. Or the prudent saver who now finds there is an almost zero return on his savings—virtuously accumulated by deferring gratification—so that the Fed can keep rates low enough to boost bank profits.

On to the biggest creditor of all, China, at risk should the United States decide to (dis)honor its obligations by running the printing presses and otherwise reducing the value of the dollars being used for repayment to a fraction of those it borrowed. China received those dollars in return for goods it sold to America, and invested them in the IOUs of the U.S. government rather than allowing its currency to appreciate and opening its markets to made-in-America stuff. And it is using the wealth, much of it amassed by stealing intellectual property, to build a military that threatens American security and economic interests around the globe. Although some of China’s gains from trade would be reduced by depreciation of the dollar, its claim to sympathy is somewhat weakened by the fact that a good portion of those gains were ill-gotten.

I exaggerate, but only to raise an important question. Is now the time to follow the biblical injunction that debtors be released from debt every seventh year? The answer is “no,” lest credit become unavailable except in the form of short-term loans. But not because of moral hazard, the valid concept misused by creditors and their supporters.

Yes, if default were to become the solution to the world’s problems—in essence a transfer of wealth from creditors to debtors—moral hazard would rear its ugly head. Pardon illegal immigrants, and millions more will troop across our borders in the hope of another pardon. Pardon debtors, and those capable of repaying their debts might decide that remission beats repayment as a financial strategy. But that is a risk the possible cost of which must be weighed against the social cost of existing policies that favor creditors: wide-scale unemployment, impoverishment, the scuppering of democratic governments in favor of “technocracies,” to mention a few. In this difficult policy area, elevating the fear of moral hazard to the sole policy criterion surely is not the answer, as John Maynard Keynes recognized in 1923 when he recommended debt cancellation to “avoid general disorders and unrest.”

So consider default—as a thought experiment if nothing else. In Europe that would take the form of refusal by sovereign governments to repay their debts, followed by negotiations with disappointed creditors. It has been done dozens of times before and, if recollection serves, without ever permanently freezing the defaulter out of world credit markets. If Greece defaults and exits the euro, it will in a stroke become free to craft its own economic policy rather than wait for the latest edict from Berlin: Harder times are ahead either way, but surely the home of democracy would rather have its voters choose their own form of suffering than wait to learn what Germany has in store for them. A “Grexit,” as it has come to be called, would leave Greece no poorer than it now is, and freer to decide how to live within its straitened circumstances rather than be told how to do so by a foreign power or an unelected technocrat imposed on it by a foreign power.

Of course, there are alternatives to widespread default. One such, alluded to above, is inflation. So desperate are the Germans to keep Greece in the euro, and to prevent a fracturing of the eurozone, that inflation-phobic Berlin is sending signals it will tolerate a bit of inflation—a tiny bit, driven by wage increases, something that Germany’s iron chancellor, Angela Merkel, cannot help but find attractive as she faces a tough reelection campaign.

Such a move would make other eurozone countries a bit more competitive with German manufacturers, although my guess is not by enough to affect the relative performance of the German and southern European economies. It is, instead, a bone thrown to those who are demanding greater flexibility on the part of Merkel, and might make it possible for France’s new Socialist president, François Hollande, to claim he has won the pro-growth concession he promised voters. With that under his belt, he can raise tax rates on the rich to 75 percent, lower the retirement age, and adopt other sops that his Socialist colleagues find attractive, proving their imperviousness to both experience and economic logic.

In America, the government could reduce the real debt burden by printing it away. Poof! and the real burden of what we owe China is reduced. Yes, incomes would be redistributed internally from creditors to debtors. And yes, that would affect the price lenders would demand of borrowers in the future. But a policy of inflation-as-default would merely be an explicit and one-shot application of what the Fed is now doing gradually and by stealth.

Does this mean I am recommending massive defaults? No: There are alternative policies that might result in more tolerable sharing of the pain of debt repayment, more tolerable than austerity alone. One such alternative would be to complete what advocates of a united Europe call the European Project: Add fiscal union to monetary union. Germany can make its high credit rating available to the troubled nations by agreeing to a eurobond. Future borrowing would be guaranteed by the eurozone as a whole, aka Germany. Investors, secure in the knowledge that they will be repaid, would make funds available at interest rates far below those being demanded of Spain and Italy, but somewhat above those offered to Germany. This is a covert transfer of income from Germany southwards, but if Germany really fears a breakup of the eurozone, it might be willing to pay this price, especially since it would be more or less invisible to most voters. To prevent Greece and others from returning to their profligate ways on the back of this German guarantee, the eurobond might apply only to some portion of the borrowings of individual countries, leaving them dependent on their own credit standing and the capital markets for the balance.

Then, too, it might well be that in some cases structural reforms associated with austerity measures can heal sick economies, or that the shovel-ready infrastructure projects that seem to exist in the fantasies of politicians actually do exist. Or better still, that some way can be found to induce private-sector players to finance infrastructure improvements such as toll roads and a usable rail system, perhaps in partnership with governments. All I am suggesting is that blind insistence on austerity and repayment is a choice, one of several, and is not graven in stone. Or even demanded by the Bible.

Irwin M. Stelzer is a contributing editor to The Weekly Standard, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).